No matter the industry, managing spending is always a fundamental focus for any executive team. In particular, variation in the purchase price of goods and services is a critical aspect of spending management. This specific kind of variation is referred to as Purchase Price Variance (PPV), and is one of the key metrics used by finance teams in the manufacturing industry to measure the variation in the price of purchased goods and services. The reason for the criticality of this metric is that the comprehension of budgeting and standard pricing provides more insights for decision making and minimizing costs in the manufacturing industry than actual prices. Direct material purchases often cover the majority of costs in manufacturing; understanding PPV helps reduce such costs from snowballing too much.
In order to mitigate excess expenses and ultimately maximize their organization’s performance, finance teams in the manufacturing industry should have a thorough understanding of what PPV is, how calculating this KPI benefits an organization, and how specific strategies and technologies best enable finance teams in manufacturing companies to calculate this critical metric.
Defining PPV & Its Significance
Purchase price variance, or PPV, is the difference between two variables: 1. the actual price paid to buy an item, and 2. The item’s standard price, which is then multiplied by the number of units purchased. For example:
A given manufacturer (Company X) could produce a widget made up of three components. The overall cost of Component A comes out to more than expected over the course of a set time period (quarter, year, etc.), which in turn pushes up the manufacturing cost of the widget. In January, Company X expected Component B to cost $1 and expected to sell 1,000 such components in Q1, so they expected the cost of goods sold to total $1,000 for Component B in Q1. In April, Company X looked back at the actual price paid for raw materials and found that the company paid a total of $1,500 for Component B in Q1.
In dollars, the purchase price variance (PPV) for Component B is $500, because $1,500 (actual price paid) minus $1,000 (standard cost) = $500.
In percent, the purchase price variance (PPV) for Component B is 50%, because $1,500 is 50% more than $1,500.
The purchase price variance that Company X discovered could be due to multiple factors, such as:
Vendors/suppliers charging more than expected
Economic trends (price of raw material, import costs, etc.)
Greater volume of products than expected that require this item
Benefits of PPV
The rationale behind using a standard price, especially in manufacturing entities, is that direct material purchases can consistently constitute 70% of all the costs of a manufacturing organization. Hence, budgeting and tracking standards vs. actual prices is a key task of many finance professionals as it is a critical metric for impactful decision-making.
Once the finance team makes a given manufacturing company aware of the variance and the factors behind it, the company can make certain decisions that affect revenue such as:
Continuing to pay a higher amount because of forces beyond the organization’s control, and select expenses that need to be cut to compensate for the higher cost
Continuing to paying the higher amount because of forces beyond the company’s control, and charging more to compensate for the higher cost
Selecting a vendor providing the item at lower cost or negotiate with the existing vendor to lower the cost
Limiting how many types of products are made from expensive materials (Widget 1, Widget 2, Widget 3)
Limit the volume of items made from expensive materials (50,000 items, 100,000, etc.)
Replace the higher-cost item with a lower-cost item in some or all products
If there are multiple sources of cost variance (i.e. multiple components cost more than expected), something else to take into account is where the biggest savings opportunities can be made by reducing that variance. Whatever changes may be made, the forecast must be revised to reflect the higher projected expenses so that the company can adhere to their budget.
Data Access & Analysis to Identify PPV
Now that the definition and benefits of identifying PPV have been fleshed out, the criticality of access to centralized, real time data should be emphasized as this is a paramount facet in exploiting PPV. Adopting the right technology empowers your finance team to best calculate this important KPI through the following two features:
Having multiple outputs/ visualization, real-time updates: The data should be presented in a spreadsheet or report or presented in a graph allowing for easy visualization, and updates in real time as a dashboard can further ease the ability of multiple stakeholders to monitor the dataset. It isn’t just the finance team that needs to look at the PPV; you’ll want to ensure that the production team and various stakeholders (i.e. quality managers, purchasing agents, logisticians, etc) have easy access to all your most up to date dashboards.
Centralizing all your data: The relevant data should all be in one place, minimizing the need to spend time collecting and consolidating the data from multiple sources
If you have access to real time data in one centralized source, your finance teams, execs and other stakeholders can drill down into the purchase price to easily identify the source of the variance. This can help them identify the source(s) of the cost variance, since there can be many different factors that impact it. Is the variance related to the supplier, the product line, the manufacturing plant, the freight carrier, the volume of production, etc. are all key considerations in this process.
With less time spent on collecting and consolidating the data, finance teams can spend more time digging into the analysis and identifying issues that can have significant impact on the company’s profitability, such as identifying the biggest cost sources and reducing those costs.
It is often difficult to view exactly how much an item costs to make, as it often requires data from multiple different sources that may be stored in different locations. Therefore this information is not always readily visible and is typically hard to pin down.
Companies can have their data stored in many different places. To be able to calculate PPV, a finance team may need information such as standard costs (could be located in a spreadsheet or an ERP), actual costs (could be located in spreadsheets from suppliers), and budget and/or last forecast to see the variance. Other purchase-price data organizations may want to pay attention to can include the manufacturing site (if more than one), unit, product line, SKU for a given time period. If there are multiple currencies involved, they also must understand the foreign exchange rates, and if there are multiple entities involved, the data may be in different ERPs and structured in different ways.
If a finance team is attempting to manage all this via spreadsheets or a combination of spreadsheets and one or more ERPs, there will be a lot of manual effort involving many different steps and data sources just to access the data and consolidate it. Such processes are error prone and time-consuming, and the purchase price may be tracked intermittently or not at all.
With all the data accessible in one place regardless of where it came from, while being stored in a unified structure, finance teams can more easily see the purchase price and analyze the variance, which also empowers finance teams to drill down into the purchase price and track the sources of the variance.
Eliminating the time spent on collecting and consolidating the data means the finance team has more time to analyze it and figure out the core of the problem, while evaluating ways to bring costs back down or compensate for them in other ways, as well as making sure to forecast correctly going forward based on the new information.
For example, an analysis of purchase price variance could indicate that a particular product is not cost-effective and the company is losing money on it. The company can then make strategic decisions to get rid of the product, or perhaps to get a more experienced manager at the site where the product is manufactured or even switch suppliers or freight carriers to lower-cost or more efficient alternatives. The outcome of the analysis should spur and support those critical decisions that directly affect the company’s bottom line.